Inflation? “It’s the economy, let’s see” | Allnews

Inflation? “It’s the economy, let’s see” | Allnews
Inflation? “It’s the economy, let’s see” | Allnews

Loomis Sayles analyzes the impact of inflation and how Fed policy changes can influence market prices.

For more than three years, investors (and the Fed) have largely ignored the “full employment” part of the Fed’s dual mandate, focusing instead on its dogged struggle to bring surging inflation under control. Between the supply-side constraints and disruptions induced by Covid, the super accommodative monetary policies of central banks on a global scale, the disproportionate fiscal stimulus in many developed countries (and particularly in the United States) and finally, the “spending of revenge” (revenge spending) post-Covid, it is not surprising that demand has finally exceeded supply. For a while at the start of 2021, one of the buzzwords was “transitory” — in other words, “this inflation that we are all experiencing globally will be transitory.” To make matters worse, global central banks and fiscal authorities were hesitant to reduce monetary and fiscal support for the then-nascent recovery.

In the United States, for much of the decade before the pandemic, monthly inflation figures of 0.2 to 0.3% (annualized to a historically acceptable level of 2.4 to 3.7%) were fairly usual. However, in early spring 2021, the monthly numbers started to reach 0.4-0.6%, then continued to climb, eventually reaching a concerning monthly rate of 0.9-1.1%+ in the early/mid of 2022, with overall year-on-year CPI peaking as high as 9% in June 2022 before starting to moderate. The Fed ultimately responded with a 525 basis point tightening from March 2022 to July 2023. It continued to reduce the size of its balance sheet through quantitative tightening. Today, two and a half years into the tightening cycle, we are back to “respectable” monthly inflation levels. And according to the Fed’s preferred inflation gauge, Core PCE, we are finally starting to move back towards a 2% level by mid-year.

Phew – mission accomplished… or not?

Regarding the Fed’s reaction function, its focus has now shifted from “price stability” to “full employment.” Fed Chairman Jerome Powell has made this clear in recent speeches and policy statements. We have been told for months that the Fed was considering a Federal Funds Rate of 5.5% as restrictive. And as inflation falls further, over time, that 5.5% nominal rate has become even more restrictive. We also know that politics works with a lag. At the July FOMC press conference and at Jackson Hole, Powell clarified that the start of policy easing should occur at the next meeting in September, but that the Fed remains “data dependent.” Does this mean the Fed is looking for further improvements on the inflation front? Not necessarily. The housing component of core inflation, in particular, has been “sticky”, but given signals from real-time rent data, we expect it to also start to fall, opening the path to a core inflation rate of around 2% by the start of next year. While last year the Fed focused primarily on inflation, it has now reversed its position, focusing more on economic growth, with employment as the key variable. Jobs data remains strong, supported by an influx of new entrants into the job market, which has allowed wages to moderate recently.

However, the unemployment trend has become much more concerning in our view, with the U-3 rate rising from a low of 3.4% a year ago to 4.3% currently, according to the Labor Department in may. So when the Fed suggests it remains “data-driven,” it stands to reason that incoming inflation data remains important. But economic data, which helps us assess the health of the economy – particularly the jobs market, will be crucial in determining, not when monetary policy easing begins, but the pace and, ultimately, the duration and extent of this relaxation.

As investors, we are interested in how this change in Fed policy may translate into market prices. Risky assets (equities and corporate credit) have seen a sharp rise, with equities currently at or near record highs, and IG and HY credit spreads approaching cycle limits, with risk supported by the prospect of more than 200 basis points of easing from the Fed over the coming year. It appears that markets anticipated an ideal soft landing where both bonds and stocks could recover and be supported by a more accommodative Fed. But we have also recently seen a (very brief) dress rehearsal of what happens when markets start to doubt this soft landing scenario and/or it turns into a harder landing.

A few weeks ago, American stocks corrected by 9 to 12% in a few days before recovering. IG and HY credit spreads also widened, briefly leading to significant negative excess (and absolute) returns, before recovering most of their losses. The current environment reminds us of the market of 2019. The Fed had just completed a tightening cycle and was implementing an easing policy to ensure a softer landing. Stocks were rising and interest rate spreads were near current, historically tight levels. One could say that valuations were “full”. However, no one expected Covid-19 and the uncertainty of this period is unprecedented in modern history.

But the scale of the market disruption was amplified by then complacent positioning. Today, given the relatively strong health of corporate and consumer balance sheets, we believe few investors expect a harder landing for the U.S. or global economy. But when markets seem to anticipate a “return to perfection,” investors generally don’t react in a very orderly way when they’re surprised. Unfortunately, the world seems more precarious lately – potential land and trade wars, geopolitics, a significant slowdown in China and the US election late this fall are all potential sources of market disruption – and these are just the “known unknowns”.

When it comes to bonds, one positive is that all-in returns remain quite attractive compared to recent history. On the other hand, the additional return potential linked to a decline in credit quality relative to governments seems much less compelling than the historical average. Therefore, we continue to advocate portfolio construction focused on quality and liquidity, which could allow better capital preservation in the event of a growth crisis or risk event, while providing the investor with liquidity. additional funds to re-engage in risky markets at potentially more attractive prices.

Disclaimer
Investing in credit involves risks, including interest rate risk, credit risk, derivatives risk and counterparty risks, sustainability risk. Past performance is not a guarantee of future results.

Marketing Communications. Reserved for professional customers only. All investments involve risks, including the risk of capital loss. The provision of this document and/or any reference to specific securities, sectors or markets herein does not constitute investment advice, recommendation or solicitation to buy or sell any securities, or an offer of services. Investors should carefully consider the investment objectives, risks and charges of any investment before investing. The analyzes and opinions mentioned herein represent the views of the referenced author(s). They are issued on the date indicated, are subject to change and cannot be interpreted as having any contractual value. In Switzerland: This document is provided by Natixis Investment Managers, Switzerland Sàrl, Rue du Vieux Collège 10, 1204 Geneva, Switzerland or its representative office in Zurich, Schweizergasse 6, 8001 Zürich.

LOOMIS SAYLES & COMPANY, LP – Affiliate of Natixis Investment Managers. Registered with the US Securities and Exchange Commission (IARD No. 105377). One Financial Center, Boston, MA 02111, USA. www.loomissayles.com

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